• Valuation ratio for S&P 500 at highest level since 2002
  • Big money managers Tepper and Druckenmiller say index overvalued
  • Goldman says expect 18% drop in the next three months

The S&P 500 index has rallied since March on reopening hopes and stimulus, but some are calling it overvalued. Concerns are growing that the mysterious COVID-19 virus will be with us longer and the economic recovery will be slower and harder to achieve than expected earlier.

The index's forward price-earnings ratio for the next 12 months has crossed 20 this month for the first time since April 10, 2002. According to FactSet, the forward 12-month P/E ratio of 20.4 on May 7 was above the four most recent historical averages for the S&P 500: 5-year (16.7), 10-year (15.1), 15-year (14.6), and 20-year (15.4). This figure has been rising sharply thanks to the "P" or price getting bigger while the "E" or forward 12-month EPS estimate gets smaller.

FactSet's John Butters noted that over the past two decades, the correlation coefficient between the daily forward 12-month EPS estimate for the S&P 500 and the daily closing price of the S&P 500 is 0.92 (where 1.0 is a perfect positive linear relationship). Meaning these two variables move in the same direction over time, so either prices are going to drop or the forward 12-month EPS estimate will rise.

S&P valuation
Source: FactSet.

Naturally investors seeing signs of the pandemic all around them are wondering if valuations are too high right now. Valuation fears were further fanned this week by two investing honchos. David Tepper, the founder of hedge fund Appaloosa Management, told CNBC on Wednesday this is the second-most overvalued market he’s seen, behind only the one in 1999. Stanley Druckenmiller of Duquesne Family Office told the Economic Club of New York on Tuesday that "risk-reward for equity is maybe as bad as I’ve seen it in my career." He added, "The wild card here is the Fed can always step up their [asset] purchases." Fed Chief Jerome Powell also threw cold water on any optimism when he said there's "a growing sense that the recovery may come more slowly than we would like." He called for more fiscal support, something investors are probably also expecting. 

At the end of last week, Goldman Sachs predicted the S&P 500 will fall 18% in the next three months, attributed the "unloved" rally to FOMO or "fear of missing out" among investors, and said valuation is "stretched" based on forecast 2021 EPS. "Skepticism abounds regarding the likelihood the rally will continue," wrote analysts in the U.S. Weekly Kickstart Report. "A single catalyst may not spark a pullback, but concerns exist that we believe, and our client discussions confirm, investors are dismissing."

The six biggest risks the brokerage believes investors are downplaying are:

  • Infection rates growing outside New York as reopenings take place
  • The re-start process taking time
  • Buybacks, the only source of net demand for shares in the past decade, falling 50% as loan reserves surge
  • Dividends being slashed this year as firms preserve liquidity
  • A new president rolling back Trump's tax cuts in November
  • Another twist in US-China trade/strategic development